Improving growth signals prompt the Fed to raise rates as expected

Article highlights

One year after its last rate hike, the Federal Reserve has again raised the target federal funds rate by 25 basis points (0.25%), to a range of 0.50%-0.75%.

With labor markets strengthening and signs of wage growth emerging, the Fed’s twin goals of full employment and stable inflation appear closer to being realized.

The Fed’s “dot plot” of expected future increases now shows three hikes in 2017, up from two previously—matching our pre-announcement expectations that the pace of tightening would accelerate slightly. On balance, the Fed indicated a continued data-dependent approach, saying monetary policy remains “accommodative,” allowing for still-gradual rate increases.

Treasury yields jumped and the S&P 500 declined in the immediate wake of the announcement, although these short-term reactions may shift as investors take more time to digest the Fed’s language.

While rising rates are a positive indicator of the economy’s health, they may lead to increased short-term volatility in financial markets.

Diversification among asset classes and sectors should help mitigate the impact that higher interest rates can have on investor portfolios.

On December 14, the U.S. Federal Reserve raised the target federal funds rate—the rate banks charge each other for overnight loans—by 25 basis points (0.25%), from a range of 0.25%-0.50% to 0.50%-0.75%. This widely anticipated increase is the Fed’s first since December 16, 2015, and the second in the current tightening cycle that the Fed initiated after seven years of maintaining a near-zero interest-rate policy.

The Fed’s unanimous decision reflects confidence that the U.S. economy is on a strong enough footing to take this second step toward normalizing interest rates. With labor markets strengthening and signs of wage growth beginning to emerge, the Fed’s twin goals of full employment and stable inflation appear closer to being realized.

Recovery across employment sectors since the recession of 2007-2009 has been slow and uneven. Nonetheless, overall job growth has returned the economy to nearly full employment, simply defined as the equilibrium between demand and supply of labor. In 2017, job opportunities will begin to outstrip available workers in some categories, which will put upward pressure on wages. Experience suggests this will unleash pent-up demand and start a chain reaction of higher incomes, spending, and growth. Full employment is also the typical juncture in the business cycle at which the Fed begins to raise rates in a more sequential pattern to help dampen any inflationary impact.

Headline inflation had meandered around the 1.5% mark until mid-2014, when falling oil prices and the rising dollar brought it down to near zero. Since the beginning of 2016, inflation has partially recovered but is not yet showing signs of heading toward the Fed’s 2% target. However, we anticipate it will approach this target by the end of 2017.

The Fed’s “dot plot” of expected future increases now shows three hikes in 2017, up from two previously—matching our pre-announcement expectations that the Fed will raise the federal funds rate by 25 basis points three times in 2017, for a total of 75 basis points. On balance, the Fed indicated a continued data-dependent approach, saying that monetary policy remains “accommodative,” allowing for still-gradual rate increases.

Market reaction and outlook

While the current rising rate environment is a positive indicator of the economy’s health, we could see increased short-term volatility in financial markets. In the immediate wake of the Fed’s announcement, both 2-year and 10-year Treasury yields jumped, and the S&P 500 fell, although these short-term reactions may shift as investors take more time to digest the Fed’s language.

Treasury yields had already begun to climb from historically low levels in the summer of 2016. They spiked further after the U.S. election in November, driven by expectations of new fiscal stimulus and other pro-growth, inflationary policies. Our 2017 outlook calls for interest rates to continue to move gradually higher on the back of accelerating economic growth. This type of scenario is normally associated with strengthening corporate earnings, providing a modestly positive backdrop for equities.

When viewed over a longer time frame, rising interest rates should be welcome news to bond investors as well, despite negative total returns in the short run. The best predictor of fixed-income returns is current yield—rising yields today should point to better returns tomorrow. And because different parts of the bond market tend to respond differently to rate increases, we believe well-diversified investors who maintain a long-term perspective will be better positioned to mitigate the near-term volatility associated with such increases.

Lastly, it’s natural to expect that higher interest rates will be accompanied by a stronger dollar. Indeed, the dollar has risen along with rates since the November election. While we do expect the dollar to climb in 2017, we are not in the camp that believes it will reach parity with the euro or surge to 130 yen—levels that would threaten to deflate corporate profits, as we saw in 2014-2015.

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